Option-Like Payoffs

It seems we have a lot of option-like payoffs looming in the next few months.

By that I mean that we have a number of events that are likely to result in either-or (binary) outcomes. Think of them as options that are going to either finish in the money or out of the money. For example, either President Obama will win re-election, or he won’t. Either the Bush tax rates will be extended, or they won’t.

Those two are truly option-like, in that they also have a fixed maturity. We will know in 33 days who the President for the next four years will be. While the Bush tax rates could always be extended retroactively to cover 2013 even if it takes until February to hammer out an agreement so that can happen, the deadline to make transactions that put income or capital gains into 2012 rather than 2013 is December 31st.

Now, what we know about options is that as you get closer to expiry and are “near the money,” your gamma increases. Gamma is a measure of how quickly the option’s delta changes – how quickly you go from feeling like a likely winner to a sure loser. An example will help. If you own $660 call options on AAPL (closing price today $666.80), and they expire in a year, then it’s probably roughly a coin flip whether those calls will end up in the money or not.[1] We would say the delta is about 0.5. If AAPL sells off to $650, then looking one year out it’s still probably pretty close to a coin flip – obviously slightly less likely, but not a bunch. Maybe 0.49 is your delta, meaning that you have something like a 1% worse chance of ending up in-the-money.

But if, on the other hand, the options are expiring at 4pm today, then your $660 call is looking pretty good when the stock is trading at $666.80 at 2pm. Your delta might be 0.95. But when, by 3pm, the stock drops to $650, your chances of winning have declined dramatically. Your delta is perhaps 0.02. Because these odds move much more dramatically, we say this option has more gamma. This is a function of both the time to maturity and the nearness of the strike to the current price.

Option traders, who try to manage their risk by delta-hedging an option, like gamma a lot if they’re long options, and dislike it immensely if they’re short options.[2] That’s because if they’re short, the hedge involves them buying into strength (aka “buy high”) and selling into weakness (aka “sell low”), and often leads to frenetic trading and on occasion, serious moves on expiry day.

Where am I going with this? An observation: as we get closer to these “option events,” if they are still not resolved one way or the other the markets will likely grow more volatile. Consider what happens to an equity investor thinking about the ‘fiscal cliff’ as year-end approaches and no deal has been struck on taxes. The investor is going to be increasingly concerned about selling stocks in which he has gains, to book those gains in 2012 in case the tax rates go up a lot. If it appears that Congress is starting to resolve some issues, then this selling pressure may relent and the markets rebound. This could go back and forth as often as the headlines change, and I will tell you that those headlines will get more frequent as the deadline draws nearer. This implies to me that market volatility will probably increase as we get closer to the election, and as we move into year-end, because of these option-like events.

There are other option-like events, although less certain in timing (Israel attacks Iran, or not. Spain asks for aid and gets it, or not. Greece defaults, or not). These will have less obvious “gamma effects,” although as long as in each case they have at least two plausible outcomes that could well happen, it will tend to contribute to volatility.

In other words, with the VIX is near the lows for the year options seem inexpensive to me.

I’m having these thoughts today because I’m watching the wild gyrations in gasoline, which was -12 cents at Wednesday’s lows (finishing -7 cents) and +14 cents today. November gas covered nearly the entire 2-month range in 2 days’ trading. More near to my heart, inflation breakevens have spiked for the last few days (+8bps today) after spending half of September retracing from a spike to touch all-time wides (see chart, source Bloomberg).

Note that this is the ten year breakeven, so it isn’t reacting here just to gasoline. And I am not aware that the outlook for growth has changed dramatically this week, nor any major money metric. What is going on? My only guess at the moment is: gamma. Small things, like a win for the Republican challenger in last night’s debate, can cause big changes in expectations, and this will become even more true as long as the race stays tight.

If we look at just that market, we could also mull the technical issues. A market that spikes to all-time highs is one thing. A market that spikes, retraces, and then rallies back to a new high would be quite another thing altogether, and might signal a new range for inflation expectations is being formed. And oh, my, would that be significant?

The equity market remains elevated, and rising inflation expectations will eventually take a toll on multiples. It always does. I don’t want to bet against equities while inflation is currently low and the Fed is trying to push the market higher, but I believe we have some volatility ahead. With implied volatilities so low on options right now, it may be worth buying puts.

[1] I am ignoring the important nuance that in this case, the forward price will be different than the spot price – it’s not important for my illustration, but you really want to compare the strike price to the forward price of AAPL, not the spot price. I make this footnote just so that readers familiar with option theory won’t think I don’t know what I’m talking about.

[2] Again, this isn’t quite true. An option trader knows that an option with a lot of gamma also has a lot of time decay, and vice versa. As a former options trader, I can tell you there is no more helpless feeling than being long gamma on expiration day and watching the market sit in a 2-tick range, knowing you’re going to lose all your time value with no delta-hedging gains, and nothing you can do about it.